Question

Parker Products manufactures a variety of household products. The company is considering introducing a new detergent. The company's CFO has collected the following information about the proposed product. (Note: You may or may not need to use all of this information, use only the information that is relevant.)

·	The project has an anticipated economic life of 3 years.
·	The company will have to purchase a new machine to produce the detergent. The machine has an up-front cost (t = 0) of $2.1 million. The machine will be depreciated on a straight-line basis over 3 years (that is, the company's depreciation expense will be $700,000 in each of the three years (t = 1, 2, and 3). The company anticipates that the machine will last for three years, and that after four years, its salvage value will equal zero.
·	If the company goes ahead with the proposed product, it will have an effect on the company's net operating working capital. At the outset, t = 0, inventory will increase by $600,000 and accounts payable will increase by $220,000. At t = 3, the net operating working capital will be recovered after the project is completed.
·	The detergent is expected to generate sales revenue of $3 million the first year (t = 1), $4 million the second year (t = 2), and $5 million the third year (t = 3). Each year the operating costs (not including depreciation) are expected to equal 50 percent of sales revenue.
·	The company's interest expense each year will be $200,000.
·	The new detergent is expected to reduce the after-tax cash flows of the company's existing products by $400,000 a year (t = 1, 2, and 3).
·	The company's overall WACC is 12 percent. However, the proposed project is riskier than the average project for Parker; the project's WACC is estimated to be 13 percent.
·	The company's tax rate is 40 percent.

Answer 1

If the discount rate is designed to represent the cost of capital for the business project, interest expense should not be included as an operating cash flow.Here I am calculating the NPV of this project,the question not specifiying what i want to calculate

Working capital increase in (t=0)=600,000-220,000=380,000

Initial cost of the product(t=0)=2,000,000+380,000=2,380,000

Depreciation Tax shield for each year=7000,000*(Tax rate)=700,000*0.4=280,000

Year1

Increased sales=3,000,000

Cost of goods sold(50% of sales)=1,500,000

increased cash flow before tax due to increase in sales=1,500,000

Decrease in after tax cash flow due to new project=400,000

Total increased after tax cash flow in year 1=(1,500,000*0.6)+280,000-400,000=780,000

Year 2

increased sales=4,000,000

Cost of goods sold(50% of sales)=2,000,000

increased cash flow before tax due to increase in sales=2,000,000

increase after tax cash flow due to increase in sales=2,000,000*0.6=1,200,000

Decrease in after tax cash flow due to new project=400,000

Total increased after tax cash flow in year 2=1,200,000+280,000-400,000=1,080,000

Year 3

increased sales=5,000,000

Cost of goods sold(50% of sales)=2,500,000

increased cash flow before tax due to increase in sales=2,500,000

increase after tax cash flow due to increase in sales=2,500,000*0.6=1,500,000

Decrease in after tax cash flow due to new project=400,000

recovery of working capital=380,000

Total increased after tax cash flow in year 3=1,500,000+280,000+380,000-400,000=1,760,000

NPV

present value factor@ 13% year 1=0.885 year2=0.7831 year3=0.6931

Present value of year 1 total cash inflow=780,000*0.885=690,300

Present value of year 2 total cash inflow=1,080,000*0.7831=845,748

Present value of year 3 total cash inflow=1,760,000*0.6931=1,219,856

Total present value of future cash flow from the project=690,300+845,748+1,219,856=2,755,904

NPV=PV of future cash flow from the project-Initial investment

=2,755,904-2,380,000=375,904

NPV=375,904, NPV is positive,company can accept the project